Category Archives: Angel Investing

I recently invested in AppAttach (http://www.appattach.com/about), an online marketplace for device manufacturers (OEMs) to find and sign up software vendors (ISVs) and receive a bounty the way the very largest hardware OEMs do.

It’s widely known that software preinstallation has become key to profitability for consumer electronic device manufacturers, but whether it’s major OEM bundling an antivirus application with a PC or a small Chinese handset manufacturer pre-installing Internet Search on a new mobile device, there’s no efficient way for buyers and sellers to quickly see what placement opportunities are available and easily conduct business. Most software vendors can only do such deals with the very largest PC manufacturers, because there is no efficient process for consummating, implementing and tracking such deals. Today’s market is crowded with new tablet entrants, who (other than the iPad) have limited market share. Likewise, the PC marketplace has a lot of custom-built PCs (like the one on which I’m authoring this blog).

AppAttach has created a marketplace and set of value-added tools and services that greatly reduce the cost of finding, negotiating, and monetizing pre-installed software and online service transactions. Simpler and less expensive transactions allow small/mid-size OEMs and ISVs to strike pre-installed distribution deals, while at the same time allowing large manufacturers to strike smaller, more targeted deals that maximize per device revenue and enhance the end user’s out-of-box-experience.

The appAttach Marketplace facilitates transactions in all major categories of software and online services, including security, productivity, browser, search, multimedia, entertainment and gaming, on devices ranging from desktop computers to mobile phones. The appAttach Marketplace is a neutral, secure interactive trading exchange where members can bid via auction-based or fixed-price listings for pre-installed software and online service placements, allowing its customers with the ability to negotiate and agree on pricing, quantity, delivery, quality and other terms online.

James DePoy, the appAttach founder, worked at the OEM group at Microsoft prior to founding appAttach, so he understands the industry dynamics and the needs of both hardware OEMs and software ISVs. His vision and drive should allow him to build an great company.

I like smaller companies that can customize a computer (or tablet) to your needs. I believe that appAttach is a missing piece of the business infrastructure that will enable smaller companies the freedom and flexibility to grow their revenues.

Virticus is an integrated set of products and services that reduce energy and maintenance costs by 30-50% through a communication and control system that allows the management of lights individually and collectively. It is a cost-effective solution that scales from 10 lights in a church parking lot to 10,000,000 lights managed by a city. Virticus is a great example of how modern network and software technologies can be a green way to lower energy consumption, while maintaining (or improving) functionality. Its customers were delighted with what it could do.

The decision to sell a company early in its life cycle is always a difficult one. While Virticus had enormous promise, it also participated in an industry with many mega-players. Customers, like municipal governments, are generally not very quick to adopt new technologies, even when they have the potential to safe budget dollars. Selling to large governmental customers (or large industrial ones, too) is particularly difficult for a small startup.

Virticus was completely financed by angels.

Congratulations to the Virticus team and board for building a great product, company and team. And then having the wisdom to sell at the right time.

Clarisonic, a signature Alliance of Angels portfolio company, was acquired by L’Oreal at the end of 2011 (http://clarisonic.com/about_us/press_releases/press/claire_release_12_15_11.php). David Giuliani, the CEO of Clarisonic, was an AoA member at the time and brought the deal to the group. Naturally, many AoA members immediately invested; I was among them. Those fortunate enough to be in that first round received a return over 20x at the time of the acquisition.

And when Clarisonic raised its second round, most reinvested and even more AoA members invested too. That round returned over10x.

This is a great success story for the community. David and the Clarisonic team kept the production in Western WA, creating over 500 jobs.

Partially as a result of this exit, we have also seen many of the angels begin to reinvest the proceeds in new deals. This is what angels do!

As early as next week, we may know whether Congress will change US securities laws to permit startups to sell stock to the general public over the internet.

You know how, today, companies raise money on Kickstarter by offering products, t-shirts, and other bennies? Imagine those same companies selling stock to investors over a Kickstarter-like platform. If the law changes  and this is something that one chamber of Congress has already passed and that President Obama supports – entrepreneurs seeking capital will have one more alternative to angel investors and venture capital firms.

Sound too good to be true? There is a catch. The proposed law (known as a “crowdfunding exemption”) would apply only to offerings that place strict limits on how much money can be raised and how much an individual investor may invest. For example, the new crowdfunding exemption might say that the startup may raise no more than $1,000,000 in a given year. And that each investor may invest no more than $1,000 per deal. (Actual limits are still being debated in Congress.)

My reply to his blog:

Bill – as always, great and thoughtful post. The original intent of the Crowdfunding bill (as drafted by Scott Brown) was to help replace Friends & Family money that has dried up with real estate prices. (Gone are the days when an entrepreneur could take out a mortgage on their home!)

As every professional angel knows, angel investing is not for the faint of heart. Many deals (even ones that seem like a sure thing) go to zero. Some are successful, but take a very long time. Almost every deal will take multiple rounds. (There is a reason for the “accredited investor” rule!) I don’t think anyone believes that a company can be funded from inception to exit by Crowdfunding.

And, angels provide much more than capital  they provide knowledge and assistance.

One historical perspective: in the early days of angel investing, VCs often would not invest in angel deals. Less experienced angels (particularly those not in groups) would screw up the valuation and terms, so VCs wouldn’t want to take the time to fix them up. As you highlight, Crowdfunded deals might follow the same path  the terms might just not be right to incent angels to invest. And cleaning up the deal for angels to follow might be a great deal of work, especially at a time like this where there are a lot of deals vying for our attention.

This next year will tell a lot about how this will play out. It’s going to be interesting!

This is another example of government beginning to understand the impact of the benefits of high-growth startups backed by angels. It is good public policy to encourage angels to help create companies through extension of the zero percent capital gains (Extension of 100% gains exemption on Qualified Small Business Stock (Sec 1202) – Current Senate bill 2050, Small Business Tax Extenders Act of 2012) and a 25% tax credit for investing in these businesses (Current Senate bill 256, American Opportunities Act, which would provide a 25 percent tax credit for investments in innovative startups).

Crowdfunding is about to be approved by Congress and signed into law by the President. For those unfamiliar with the concept, you can read Wikipedia (http://en.wikipedia.org/wiki/Crowdfunding) or simply put it is raising money for startups, typically via the Internet, in small chunks from people who may never meet with or diligence the company. Crowdfunding has been used in some non-profits for years and has been successful in Europe for the last two or so years as well.

Most existing investors in this early-stage asset class hear of crowd funding and have the immediate reaction: “Won’t this lead to massive fraud?” Today, investments in unregistered securities require that all investors be “accredited” so that they are assumed to understand the risks in these investments and ensure that sophisticated investors carefully vet deals to ensure that there isn’t fraud.

But, times change. Some VCs and Angels have become fabulously wealthy and famous by investing in early-stage companies, and the media has made a big deal about this. Think Google, Facebook, and even Microsoft. And, in our current economic malaise, creating high-growth, innovative startups is seen as a way out of the mess. But many innovative startups fail in trying to raise money. Angels do their part (see many of my previous posts). But many believe that the need is greater than sophisticated (“accredited”) Angels can finance.

So.. the idea of Crowdfunding has gained great momentum. The current vehicle, H.R. 2930, the Entrepreneur Access to Capital Act, as amended and approved by the House Financial Services Committee on October 26, 2011, (see http://financialservices.house.gov/UploadedFiles/hr2930ai.pdf for the original). The amendments are important, since they lower the size of the amount raised. While the situation is still fluid (the House reportedly just passed its bill and the Senate is in draft), it appears that there will be a $1M annual cap on raising money through Crowdfunding. Crowdfunding is exempt from current broker-dealer rules. Other issues, like how companies handle scores or hundreds of investors or allowable fees that Crowdfunding platforms can charge, remain up in the air.

I have heard rumors about this being done in Europe for the last several years, but cannot substantiate that startup companies have been funded this way. Wikipedia reports that “One of the pioneers of crowd funding in the music industry have been the British rock group Marillion. In 1997 American fans underwrote an entire U.S. tourto the tune of $60,000, with donations following an internet campaign ” And movies have been known to use Crowdfunding. Any readers with more data?

This is a brave new path for the US. While many (myself included) think that our current SEC regulations that limit investments in startups to “accredited investors” are too narrow and should allow other knowledgeable investors to participate, there is established law and precedent for the investment market. I worry that we might be opening Pandora’s box. Many startups fail and investors that are not willing or able to do due diligence should not be investing in them. It is one thing for sophisticated, accredited investors, like me, to invest in a company and loose their investment. We understand the risk going in. We did our due diligence on the management team, the market, and the technology and reached a positive conclusion. It is quite another thing for someone to “advertise” a deal to the Crowd and have people send them money based solely on the company’s information without any substantiation.

I believe that broadening the participation in the early-stage asset class is a good idea and Crowdfunding is one way to achieve this. I just don’t want some bad actors who use the Crowdfunding mechanism for fraudulent transactions to poison the entire asset class. I think it would behoove both the entrepreneurs that raise money with Crowdfunding and the investment community to find a way to have a trusted platform that verifies that the company is who they say they are and that some investment professional has done due diligence appropriate to the investment.

I also worry that Crowdfunding could lead to some very high priced deals. Investment professionals (including “Professional Angels) have a great deal of experience setting the price for early stage deals. This experience comes from many years of investing, forecasting companies’ success and capital needs, and understanding how exits are likely to occur. Without this discipline, prices might not reflect true value. For example, if an entrepreneur is told by the investment professionals in their community that an appropriate valuation for their company is $2M, but they go to the Crowd with a $10M valuation and raise $500k, what happens when they need to do their next round? After they have spent the $500k, they might approach either Angels or VCs who will then set the price well below $10M. The Crowd will then find that their investment is worth very little. If the Crowd understands that risk, I have no problem with Crowdfunding, but if this isn’t transparent or well-disclosed, I think we could have many disgruntled investors.

I really want Crowdfunding to work. I don’t want a bunch of “mom and pop” unsophisticated investors ripped off.

Should entrepreneurs be asked to pay angels and angel groups for the opportunity to present their business?

As the seed stage/angel asset class becomes more prominent and popular, this becomes an ever more frequent question. There was a blow up about a year ago when Jason Calacanis took on the Keiretsu Forum and the amount they charged early stage companies. Not much has changed, but the number of people trying to part the entrepreneurs from their money has done nothing but increase.

Let me start with my emotional answer. It is hard for me to understand why an entrepreneur who has quit their job, mortgaged their home, and gone “all in” on their startup should pay a bunch of rich people for the privilege of pitching their deal. It just seems wrong. And, from my point of view, not something I would do.

But, if I take an entrepreneur’s point of view, I need to raise money. It’s such a daunting task and many entrepreneurs really neither have the time nor resources to pull it off. So, unless I see an alternative, if someone offers me a path to raise money, I take it. If I have to pay $10-25k to raise my needed $500k, I probably take it. I don’t ask questions like:

“Are the investors coming in aligned with our strategy?”

“How many investors are in my deal?”

“What impact do they have on my structure?”

“Do the deal terms mesh with raising more money later?”

And perhaps most importantly, “If I take this money, does it eliminate other sources, especially if I pay a fee to a broker?”

Experienced, professional angels have been through this lots. Groups like the Alliance of Angels don’t charge a fee for raising money for entrepreneurs. We help get deal terms that are fair to both entrepreneurs and investors, and allow for the necessary future financings (even when the plan says there won’t be any other financings).

It is hard to clean up the mess from a poorly constructed and overpriced financing. Most investors won’t do the clean up and instead will just pass on the deal.

Carve outs for management is a tool that is often overlooked by boards in angel-backed companies. It is a tool that can be a critical in making an acquisition occur, but is difficult to get right. First of all, both management and the board are often too close and emotionally involved to make a clear decision.

For those that aren’t familiar with the concept of a carve out, it is a payment to management, from the proceeds of a transaction, that is paid out before investors are paid the amount they would otherwise be due from the sale of the company.

Having served on more than my share of boards, and often on the comp committee, I am often asked about the following situation, which is typical of one where a carve out occurs:

A company has taken quite a bit of investment, usually from institutions and angels.

The deal that was struck has a liquidation preference (if you don’t know what this means, you should educate yourself). Good terms for companies meeting their goals are 1x participating preferred (sometimes capped); bad terms are 2x to 3x and usually granted when a company is in trouble and needs to raise money.

Acquisition seems like the best alternative, but the offers are for less than the liquidation preference (or not much more than the preference).

In this case, the common stock and options are essentially worthless. The founders, employees, and others who bet on the upside find themselves in the position of having worked for little-to-no upside (or in the case of board members or consultants who took options  nothing!).

What is the board to do?

Here is my perspective from serving on dozens of boards and many comp committees:

It was management’s sweat that got the company to exit. This needs to be rewarded.

On the other hand, the board needs to recognize that management did not deliver the value that was promised when the money was taken. (Nor did the board.) It is not fair to give management a great return, while investors lose money.

The board should try, as a first priority, to ensure that management gets a good deal from the acquiring company. This is good for the acquirer and allows more of the proceeds to go to investors.

One often hears that management is unwilling to allow a deal to proceed if they don’t make enough money. And therefore they would rather the company stay in operation, even if it means a greatly reduced valuation. If the original deal terms don’t either carry enough voting shares, or the rights to force the sale, then the investors might be screwed. This is why alignment with the entrepreneur and deal terms can matter.

Finding a fair solution is often difficult. Hiring an experienced person/consultant might be a good idea, if the board and management are willing to follow their dispassionate advice.

If a carve out is necessary, I believe that it should be graduated (like a graduated income tax). In that way, as the investors do better, management increasingly does better. This aligns incentives. For example, if the liquidation preference is $10M and the acquisition will be in the range of $5-15M, the carve out might look like this:

5% of proceeds for the first $5M (which is $250k at $5M)

Between 5-10M, $250k plus 7.5% of the amount over $5M, which is $375k at 10M

$875k plus 10% (plus the value of their stock, which is now in the money) for any amount over $10M

This seems to give both aligned incentives and balance the reward for management with the need to get investors their money back.

Of course, all of this looks much better when the company sells for a lot more than was invested!

One of the good things about the steady success of the Alliance of Angels (www.allianceofangels.com) is the visibility it gives the Managing Director to virtually every deal in the Northwest. However, this also means that the AoA Managing Director is a highly sought-after professional. Our current managing director, Greg Huey, has decided to move on to become the President and COO of Glassybaby (http://www.glassybaby.com/). While we are exceedingly sad to see Greg leave, we are delighted that the Seattle startup community has a new and competent executive. Over the last two plus years, Greg has ably driven the AoA program to new heights, contributing to innumerable companies and making sure the very best were well represented to the AoA. The AoA set new records for annual investment in two successive years with Greg at the helm, a significant achievement while simultaneously navigating the organization through the economic downturn. We look forward to building on the progress AoA has made under his leadership. Greg leaves AoA having firmly established our program as a national model for entrepreneurial investment. While he leaves some big shoes to fill, we are confident that the opportunity to work with one of the most active angel groups in the nation will attract a successor who will continue this great work.

So now it’s time to find Greg’s replacement. The ideal candidate should have several years of business experience, and have substantial knowledge of the investment business (especially early-stage investing) either representing a venture capital or other private equity firm. An MBA would be a plus. The job description can be found here: AoA Managing Director Job Description.